You might have noticed all the hype around the IPO of Burger King, Zomato, Nykaa, and PayTM. Don’t tell us that all the excitement has not made you curious enough to find out everything related to the term IPO!
In this blog, we are going to share all that you should know before you even consider investing in an IPO. If you are content with investing in a mutual fund, it is great but knowing a bit about IPO won’t hurt either. So, without further ado, let’s get started with the basics:
The very first listing of the shares of any company on a stock exchange (like the National Stock Exchange or NSE) is called an Initial Public Offering (IPO). For example:
PayTM was a company owned by a handful of individuals or investors making it a privately owned company (which means it was not listed on any of the stock exchanges). However, when PayTM finally listed the company’s shares on the public stock exchange, we referred to this listing as the PayTM IPO and the company became a publicly listed company.
A privately-owned company launches an initial public offering (IPO) so the shares could be available for the general public to buy.
Does a Private Company Offers IPO Only to Raise Capital?
It is often assumed that a company decides to initiate IPO only to raise funds to grow and expand the operations, but it is not the case. Of course, it is one of the main reasons but there could be several other motives behind companies initiating IPO.
In fact, private companies usually have different reasons to attract public investors. Let’s have a look at some of the most common motives behind IPOs around the world:
- As discussed earlier, raising capital is among the most common motives behind an IPO. When companies need to raise additional capital, they prefer to launch IPO instead of reaching out to any financial institution for corporate finance, loans, etc.
- Another common reason to go public is to garner publicity, build brand recognition, and gain the trust of the buyers. Besides, it also builds credibility for the company, as being listed on the stock market improves the public image of the company.
- Companies also launch IPO as it offers price transparency among shareholders who have been associated with the company for a very long time.
- Creating exit opportunities for early investors, angel investors, and venture capitalists is also one of the main motives behind IPOs. For example, if a venture capitalist wishes to exit a company and reap returns on his/her investments, IPOs make for an excellent exit strategy.
Types of IPO
Initial public offerings are basically categorized into two broad categories discussed below:
Fixed Price Offering
When the initial offering price is mentioned (in the prospectus) by the company, the IPO is referred to as a fixed price offer. The company issues a prospectus that contains the total number of shares that the company is offering along with the exact price.
The investors already know the issue price of the IPO stocks and pay the full amount upfront during the application phase of the IPO process. Moreover, the demand for such stock is only known to the company only after all the stocks are issued.
Book Building Offering
Book building offering is a bit different from fined price offering on the grounds that the company initiating the IPO allocates a price band of 20% to the stocks.
The lowest price of the shares is known as a floor price, whereas, the highest price of the shares is termed as cap price.
Under book building offering, the to-be public company has to issue a Red Herring Prospectus. It contains details of the total number of company shares that are available in the IPO, along with the price band.
Depending on the price band, interested investors bid for the IPO stock. While bidding, the potential investors specify the amount per share that they are ready to pay as well as the number of shares that they are interested to buy.
Once this process is complete, the private company realizes the exact demand and, thereafter, the final price of IPO shares is decided accordingly.
The Right Steps to Invest in IPO
Contrary to common belief, investing in an IPO is not always profitable. As discussed earlier, all of the initial public offerings are not initiated to raise capital. Some IPO only acts as an exit strategy for early investors.
Therefore, irrespective of the IPO hype in the stock market, you have to take certain steps before you decide to invest the hard-earned money sitting in your bank account. Here is what seasoned private investors do before purchasing IPO shares:
The first step when you have to invest even a penny is to do proper research. This step becomes even more fundamental when you have to invest in IPO.
We are not just discussing finding out what the does or how popular it is. You also have to consider its top-line and bottom-line growth, the potential of the company in the market, and the company’s business plan. Moreover, you also have to consider several other factors like the credit records, company founders, company files, financial health, key strengths, strategy, etc.
You can also take the help of the internet to see what the company insiders are talking about. If you can, it would be best to dig deeper and find out about the venture capitalists. Moreover, you also have to compare the IPO that you are interested in with all the past and upcoming IPOs.
Scan the DRHP Document Thoroughly
Carefully read the Draft Red Herring Prospectus (DRHP) document which contains all the details regarding the IPO and the company. For example the purpose of raising the new equity capital, balance sheet, company’s business plan, a copy of the underwriting agreement, legal opinion on the listing, etc.
Reading this document will help you understand a lot about the company and will give you a lot of clarity on whether you should invest in the particular IPO or not.
Read more about Red Draft Herring here.
Analyze the Backgrounds of the Promoters and Management
Once you are done with the research and reading the DRHP document, your next step should be to find out about the past performance and records of the Promoters involved in the IPO process. Moreover, it will also do you good to analyze the past records of the members involved in top-level management.
These seemingly simple steps will help you speculate the chances of the success of an IPO. All institutional investors follow this step to ensure that they don’t bear any losses.
Know Your Investment Purpose and Find Out the Risk Factors
The next, but one of the most crucial steps is to understand why you wish to invest. For example, in most cases, the aim is to make quick profits by selling the company’s shares in an open market.
However, you might also look at the bigger picture and future growth by holding the shares. No matter the circumstances, you must have a clear purpose as it will help you take action accordingly.
IPO stocks are not traded freely until they are listed and there is no guarantee as to how the market will react. Therefore, you must understand the market risks thoroughly before you decide to invest in IPO instead of treasury bills.
Read the complete guide: 11 Steps to investing in IPO
How to Invest in IPO?
Investing in an initial public offering is not as complex as you are forced to believe. It is actually quite easy. All you have to do is to follow the steps mentioned below to start investing in an IPO:
Open a Demat Account
A Demat account acts as a medium to buy, hold, and sell stock market shares and other securities. For example bonds, debentures, government securities, mutual funds, initial public offering (IPO), exchange-traded funds (ETFs), etc.
Here is what you need to do in order to open a Demat Account:
- First of all, you have to select a Depository Participant (DP). A DP is basically any authorized brokerage firm, financial institution, or investment bank that helps you create a Demat account. (There are multiple options for DP and you must consider brokerage charges, annual charges, and leverage offered before making a choice.)
- Fill up the account opening and KYC form and submit it with an attached passport-sized photograph and copies of:
- PAN Card
- Residence Proof
- ID Proof
- Carefully read and sign the agreement that contains the rules, regulations, and rights related to acquiring a Demat account.
After completing this process, your account will be opened and you will receive a unique Client ID from your Depository Participant. You can also apply online to create your Demat account and a representative of the selected DP will get back in touch with you to complete the above-mentioned formalities.
Complete the Application Process
Once you select an IPO, of a private company, to invest in and decide the number of shares you want to purchase, the next step of your IPO process should be to duly fill up the application form. You can apply for an IPO either through your bank account or trading account.
To complete the application process, every investor must have an Application Supported by Blocked Account (ASBA) feature to arrest funds in the investor’s bank account.
You may think that the bidding process is only applicable to Book Building Offerings where you have to place your bids for the stock price from the initial price band. However, that is not the case.
You also have to place your bid for the number of shares that you wish to buy, be it a book building offering or fixed price offering. As soon as you place the bid for an initial public offering (IPO), the amount equivalent to the total price of your bid will be blocked in your account.
When the investors get a full allotment of the shares that they bid for, they receive a Confirmatory Allotment Note (CAN) within six working days.
As soon as the shares are allotted, they are transferred to the investor’s Demat account.
However, when the demand is higher than the number of stocks reserved for the initial sale, the private investors get a lesser number of shares than what they had bid for. In this case, the bank unlocks the funds that were blocked after bidding, either partially or entirely.
After this, the private shareholders have to wait for a period of seven days for the stocks to get listed on the securities market.
Investing in an IPO is a complex process and involves market risks. Therefore, it is always suggested to take the help of an established stockbroker.
It is mainly because it might not be easy for you to purchase the shares until the prices of shares are much higher than the IPO price even if you have a trading account.
Check the latest IPOs: Zerodha IPO listings
Who is Eligible to Invest in Initial Public Offering?
Any person who wishes to invest in an initial public offering (IPO) in India must qualify the following norms:
- The investor should be an adult
- The investor should be capable of entering a legal contract
- It is mandatory to have a bank account number
- The person must have a PAN card issued by the Income Tax department of India
- It is also mandatory for public investors to have a Demat account
- Even though having a trading account is not mandatory to buy IPO stock you will need one if you wish to sell your IPO shares after listing
Commonly Used Terms Related to IPO
You might have heard a lot of terms related to IPO that are quite confusing. In this segment, we are explaining the most common terms used in reference to IPOs. Without further ado, let’s get started:
A company selling shares in the primary market is known as an issuer company or issuer.
You may consider the underwriter as the intermediary between the issuer company and investors. It is through their assistance that the company decides the IPO price, setting the practical expectation to raise money, the types of securities to be sold, etc.
Draft Red Herring Prospectus
Draft Red Herring Prospectus or DRHP is basically a prospectus document that a to-be public company issues so the investors could know all about their IPO.
A company also needs to acquire approval from the Securities and Exchange Board (SEBI) before issuing the prospectus. A DRHP document contains the following details:
- Purpose of raising equity capital through the IPO
- Balance Sheet
- The expense of the Promoters
- Disclose financial proceeds of the company
- Commissions and discounts of the underwriters
- Copy of the underwriting document
- Name and address of all the officers, directors, underwriters, and stockholders who possess 10% or more of the currently outstanding stock
- Legal opinion on the listing
Fixed Price IPO and Price Band
The issue price in a fixed price IPO is pre-decided and is not affected by the demand for the stocks.
However, when a price band is assigned for an IPO, the offering price of the stock will fall within a predefined range depending on the demand.
Under Subscription and Oversubscription
When an IPO does not receive enough applications for the total number of shares issued in the open market, the phenomenon is called under subscription.
On the contrary, when an IPO listing receives more applications than the number of shares offered to the market, the phenomenon is termed as oversubscription.
Green Shoe Option
When the demand for the shares increases more than expectations (oversubscription) then, as per the underwriter agreement, the underwriter is authorized to sell more shares. In such an event, the issue may release additional shares (secondary offering) in the secondary market.
The process that helps underwriters and merchant bankers to decide the stock price of the IPO is called book building.
An investment bank, or investment banking firm, is an institution that acts as a facilitator of large and complex financial transactions. Be it a special purpose acquisition company, private company, or publicly traded company, every organization relies on investment banks in one way or other.
For example, investment banks also serve the purpose of an underwriter.
Benefits of Investing in IPO
The risk associated with an IPO is high and so is the probability of profit. The right choices will give you the following benefits:
First Mover’s Advantage
When you purchase a notable company’s share during an IPO, you get the first mover’s advantage. It is obvious that the prices of the share are bound to rise as soon as the shares enter the secondary market. This is one of the main reasons that institutional investors have a preference for IPO.
If you know that the company has the potential to grow then investing in an IPO is a very smart decision. It is because the value of your shares will increase in direct proportion to the growth of the company. In short, it might be more beneficial than investing in mutual funds.
Investing in an IPO gives you quick money in the form of listing gains. For example:
Let us suppose that you invested in an IPO with an offering price of INR 100. However, when it opened on the stock market, the listing price was INR 125. Thus, you will make a profit of 25% in a very short span of time.